CHAPTER TEN

macro Aggregate Demand I

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint Slides
by Ron Cronovich

2002 Worth Publishers, all rights reserved

 In this chapter you will learn
the IS curve, and its relation to
the Keynesian Cross
the Loanable Funds model
the LM curve, and its relation to
the Theory of Liquidity Preference
how the IS-LM model determines income
and the interest rate in the short run when
P is fixed

CHAPTER 10 Aggregate Demand I slide 1

 Context
Chapter 9 introduced the model of aggregate
demand and aggregate supply.
Long run
prices flexible
output determined by factors of production &
technology
unemployment equals its natural rate
Short run
prices fixed
output determined by aggregate demand
unemployment is negatively related to output
CHAPTER 10 Aggregate Demand I slide 2
 Context
This chapter develops the IS-LM model, the
theory that yields the aggregate demand
curve.
We focus on the short run and assume the
price level is fixed.

CHAPTER 10 Aggregate Demand I slide 3

 The Keynesian Cross
A simple closed economy model in which
income is determined by expenditure.
(due to J.M. Keynes)
Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned
expenditure: unplanned inventory investment

CHAPTER 10 Aggregate Demand I slide 4

 Elements of the Keynesian Cross
consumption function: C = C (Y T )
govt policy variables: G = G , T =T
for now,
investment is exogenous: I =I
planned expenditure: E = C (Y T ) + I + G

Equilibrium condition:
Actual expenditure = Planned expenditure
Y = E
CHAPTER 10 Aggregate Demand I slide 5
Graphing planned expenditure
E
planned
expenditure
E =C +I + G

MPC
1

income, output, Y

CHAPTER 10 Aggregate Demand I slide 6

Graphing the equilibrium condition
E
planned E =Y
expenditure

45

income, output, Y

CHAPTER 10 Aggregate Demand I slide 7

The equilibrium value of income
E
planned E =Y
expenditure
E =C +I + G

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I slide 8
An increase in government purchases
E Y

=
At Y1, E E =C +I +G2
there is now an
unplanned drop E =C +I +G1
in inventory

so firms
increase output,
and income Y
rises toward a
new equilibrium E1 = Y1 Y E2 = Y2

CHAPTER 10 Aggregate Demand I slide 9

 Solving for Y
Y = C + I + G equilibrium condition

Y = C + I + G in changes

= C + G because I exogenous

= MPC Y + G because C = MPC Y

Collect terms with Y Finally, solve for Y :

on the left side of the
equals sign: 1
Y = G
(1 MPC) Y = G 1 MPC

CHAPTER 10 Aggregate Demand I slide 10

The government purchases multiplier
Example: MPC = 0.8
1
Y = G
1 MPC
1 1
= G = G = 5 G
1 0.8 0.2

The increase in G causes income to increase

by 5 times as much!

CHAPTER 10 Aggregate Demand I slide 11

The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the G multiplier equals
Y 1
=
G 1 MPC

In the example with MPC = 0.8,

Y 1
= = 5
G 1 0.8

CHAPTER 10 Aggregate Demand I slide 12

Why the multiplier is greater than 1
Initially, the increase in G causes an equal
increase in Y: Y = G.
But Y C
further Y
further C
further Y
So the final impact on income is much
bigger than the initial G.

CHAPTER 10 Aggregate Demand I slide 13

 An increase in taxes
E Y

=
Initially, the tax E
increase reduces
E =C 1 +I +G
consumption, and E =C 2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
inventory buildup
so firms
reduce output,
and income Y
falls toward a E2 = Y2 Y E1 = Y1
new equilibrium

CHAPTER 10 Aggregate Demand I slide 14

 Solving for Y
eqm condition in
Y = C + I + G
changes
= C I and G exogenous

= MPC ( Y T )
Solving for Y : (1 MPC) Y = MPC T

Final result:
MPC
Y = T
1 MPC

CHAPTER 10 Aggregate Demand I slide 15

 The Tax Multiplier
def: the change in income resulting from
a $1 increase in T :
Y MPC
=
T 1 MPC

If MPC = 0.8, then the tax multiplier equals

Y 0.8 0.8
= = = 4
T 1 0.8 0.2

CHAPTER 10 Aggregate Demand I slide 16

 The Tax Multiplier
is negative:
A tax hike reduces
consumer spending,
which reduces income.
is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
is smaller than the govt spending multiplier:
Consumers save the fraction (1-MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
CHAPTER 10 Aggregate Demand I slide 17
 The Tax Multiplier
is negative:
An increase in taxes reduces consumer
spending, which reduces equilibrium income.
is greater than one (in absolute value):
A change in taxes has a multiplier effect on
income.
is smaller than the govt spending multiplier:
Consumers save the fraction (1-MPC) of a tax
cut, so the initial boost in spending from a tax
cut is smaller than from an equal increase in G.
CHAPTER 10 Aggregate Demand I slide 18
 Exercise:
Use a graph of the Keynesian Cross
to show the impact of an increase in
investment on the equilibrium level of
income/output.

CHAPTER 10 Aggregate Demand I slide 19

 The IS curve
def: a graph of all combinations of r and Y
that result in goods market equilibrium,
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
Y = C (Y T ) + I (r ) + G

CHAPTER 10 Aggregate Demand I slide 20

 Deriving the IS curve
E E =Y E =C +I (r )+G
2

r I E =C +I (r1 )+G

E I

Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 21

Understanding the IS curves slope
The IS curve is negatively sloped.
Intuition:
A fall in the interest rate motivates firms to
increase investment spending, which drives
up total planned spending (E ).
To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y ) must
increase.

CHAPTER 10 Aggregate Demand I slide 22

The IS curve and the Loanable Funds model

(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y

CHAPTER 10 Aggregate Demand I slide 23

Fiscal Policy and the IS curve
We can use the IS-LM model to see
how fiscal policy (G and T ) can affect
aggregate demand and output.
Lets start by using the Keynesian Cross
to see how fiscal policy shifts the IS
curve

CHAPTER 10 Aggregate Demand I slide 24

 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

G E Y E =C +I (r1 )+G1
so the IS curve
shifts to the right.
Y1 Y2 Y
The horizontal r
distance of the r1
IS shift equals
1 Y
Y = G IS2
1 MPC IS1
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 25

Exercise: Shifting the IS curve
Use the diagram of the Keynesian Cross
or Loanable Funds model to show how
an increase in taxes shifts the IS curve.

CHAPTER 10 Aggregate Demand I slide 26

The Theory of Liquidity Preference
due to John Maynard Keynes.
A simple theory in which the interest rate
is determined by money supply and
money demand.

CHAPTER 10 Aggregate Demand I slide 27

 Money Supply

The supply of r
(M P)
s
interest
real money rate
balances
is fixed:
(M P) =M P
s

M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I slide 28

 Money Demand

Demand for r
(M P)
s
interest
real money rate
balances:
(M P)
d
= L (r )

L (r )

M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I slide 29

 Equilibrium

The interest r
(M P)
s
rate adjusts interest
rate
to equate the
supply and
demand for
money:
r1
M P = L (r ) L (r )

M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I slide 30

How the Fed raises the interest rate
r
interest
rate

To increase r,
r2
Fed reduces M
r1
L (r )

M/P
M2 M1 real money
P P balances

CHAPTER 10 Aggregate Demand I slide 31

CASE STUDY
Volckers Monetary Tightening
Late 1970s: > 10%
Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
Aug 1979-April 1980:
Fed reduces M/P 8.0%
Jan 1983: = 3.7%
How
How do
do you
you think
think this
this policy
policy change
change
would
would affect
affect interest
interest rates?
rates?
CHAPTER 10 Aggregate Demand I slide 32
 Volckers Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity Theory,
Liquidity Preference
model Fisher Effect
(Keynesian)
(Classical)
prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4%

1/1983: i = 8.2%
outcome 4/1980: i = 15.8%
CHAPTER 10 Aggregate Demand I slide 33
 The LM curve
Now lets put Y back into the money demand
function:
(M P)
d
= L (r ,Y )

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand
for real money balances.
The equation for the LM curve is:
M P = L (r ,Y )

CHAPTER 10 Aggregate Demand I slide 34

 Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P

CHAPTER 10 Aggregate Demand I slide 35

Understanding the LM curves slope
The LM curve is positively sloped.
Intuition:
An increase in income raises money
demand.
Since the supply of real balances is fixed,
there is now excess demand in the money
market at the initial interest rate.
The interest rate must rise to restore
equilibrium in the money market.

CHAPTER 10 Aggregate Demand I slide 36

 How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P

CHAPTER 10 Aggregate Demand I slide 37

Exercise: Shifting the LM curve
Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
Use the Liquidity Preference model
to show how these events shift the
LM curve.

CHAPTER 10 Aggregate Demand I slide 38

 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

Y = C (Y T ) + I (r ) + G IS
M P = L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income

CHAPTER 10 Aggregate Demand I slide 39

 The Big Picture
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

CHAPTER 10 Aggregate Demand I slide 40

 Chapter summary
1. Keynesian Cross
basic model of income determination
takes fiscal policy & investment as exogenous
fiscal policy has a multiplied impact on income.
2. IS curve
comes from Keynesian Cross when planned
investment depends negatively on interest rate
shows all combinations of r and Y that
equate planned expenditure with actual
expenditure on goods & services

CHAPTER 10 Aggregate Demand I slide 41

 Chapter summary
3. Theory of Liquidity Preference
basic model of interest rate determination
takes money supply & price level as exogenous
an increase in the money supply lowers the
interest rate
4. LM curve
comes from Liquidity Preference Theory when
money demand depends positively on income
shows all combinations of r andY that equate
demand for real money balances with supply

CHAPTER 10 Aggregate Demand I slide 42

 Chapter summary
5. IS-LM model
Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium
in both the goods and money markets.

CHAPTER 10 Aggregate Demand I slide 43

 Preview of Chapter 11
In Chapter 11, we will
use the IS-LM model to analyze the impact
of policies and shocks
learn how the aggregate demand curve
comes from IS-LM
use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks
learn about the Great Depression using our
models

CHAPTER 10 Aggregate Demand I slide 44

CHAPTER 10 Aggregate Demand I slide 45